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Attorneys to pay Tax on Contigency Fees taken from Plaintiffs

published May 09, 2005

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<<The Supreme Court recently ruled that the amounts of the settlements plaintiffs pay to their attorneys should be included as part of their gross income on their income tax forms. The two cases, which the Supreme Court consolidated for its ruling, Commissioner v. Banks and Commissioner v. Banaitis, both had plaintiffs who had won settlements in discrimination cases against their employers, but had not claimed the settlements as income.

"There has always been a lot of back and forth on this issue," says Charlie Stevens, a partner in the Milwaukee office of Michael Best & Friedrich, LLP, "and not just in terms of case law, but also Internal Revenue Service guidance." Stevens notes that even with all the previous court and IRS guidance in the past, the issue was still, "to use the technical legal term, 'mushy.'"

The First, Fourth, Seventh, Eighth, Tenth, and Federal Circuit Courts have held that the awards are gross income to the plaintiff, while the Fifth, Sixth, and Eleventh Circuits have said no. The Ninth has ruled both ways, based on the specific circumstances of the individual case.

Now, however, since the Supreme Court ruling, not only is the award subject to income tax, so are attorney's fees, says Stevens, which is where the American Jobs Creation Act of 2004 comes in to play. Last year, Congress passed the Act, which contains a section that allows a taxpayer to deduct attorney's fees and court costs paid in any lawsuit that involves a claim of unlawful discrimination or other type of employment-related claim. The taxpayer can do this even if he or she is not otherwise itemizing deductions.

Even with the American Jobs Creation Act, however, a plaintiff could actually win a case but end up owing money. This happened to a Chicago police officer who, after receiving a judgment of $300,000, owed almost $100,000 for legal fees after paying taxes on the $950,000 award. Stevens suggests that, in particular, a plaintiff may find the alternative minimum tax triggered with such a settlement. "This would be especially true if the plaintiff only collected a small award, while the employee's attorney collected a more substantial award in fees," says Stevens.

Explaining it to clients
Plaintiffs' lawyers should prepare their clients for the fact that certain amounts of the settlement will be taxable. Some or all of the settlement could actually be considered wages—which means it would be subject to withholding, FICA, and Medicare taxes—while the fees paid to attorneys will be considered as non-wage income. However, depending on the claim, they may be able to deduct those fees on their income tax returns, even if they do not itemize. That is the good news with the legislation, says Stevens. The bad news is that attorneys are going to have to spend significant time explaining tax liability to their clients.

The first thing employment attorneys need to do is to not assume that if they knew what the law was a year ago that that is still the case. "Every lawyer who engages in settlement of employment claims has to revisit this issue," advises Stevens. "Furthermore, they need to make sure they do not get caught up in the issue of whether something is taxable or nontaxable and think that a 1099 form will protect the employer." A secondary issue is even assuming settlement consideration is taxable: is it wages to be reported on a Form W-2 or non-wages to be reported on a Form 1099?

In addition, Stevens notes, you should raise the topic of taxation of the consideration very early in the settlement discussions. And that means with both sides. "The last thing you want is to find out after you have reached a settlement that the other side learns there is going to be a tax impact and they suddenly call everything off. Or they want to find a way for the employer to handle the employee's tax impact."

The impact
Stevens does not see any real changes in the way some plaintiffs set up fee agreements with their lawyers. "In many of these cases, the plaintiffs are looking for the maximum amount of cash to change hands," he notes. "So I do not believe that we will see much change in the structure of contingency-fee arrangements because of this ruling."

Actually, he points out, now that there is better guidance and both plaintiffs' and defense lawyers are figuring it out, it should make settlements somewhat easier. "One of the problems we have had in the past was that sometimes even the plaintiff's lawyer was unsure of what the law was. Now, however, because of this ruling, there is greater dialogue out there about how this works, and that helps."

One type of case may go by the wayside, admits Stevens: those cases where employees do not really care that much about how much money they win. They are more interested in making sure their employers know they did something wrong. These types of cases may produce small awards for the plaintiff, even though their attorney's fees may be substantial. It may be the case, he says, that if an individual plaintiff understands that the attorney's fees are going to be counted as income and taxed, he or she may be less inclined to pursue those claims, or he or she may ask for a more substantial settlement.

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